A U.S. District Court has ruled against the Internal Revenue Service that a company putting together gift baskets qualifies for a deduction for domestic production activities.

Houdini Inc., is an S corporation involved in the design, assembly, and sale of gift baskets and gift towers through both wholesale and retail channels. It has two facilities in Fullerton, Calif., and one facility in Buena Park, Calif., employing about 300 employees. During its peak season of August through December, Houdini hires about 4,000 temporary workers, and can complete up to 80,000 baskets in a day.

On its amended tax returns for 2005 and 2006, Houdini claimed Section 199 domestic production activities deductions based on the gift boxes it makes, and passed the deductions through to its shareholders, Timothy Dean and John O’Brien. After paying Dean and O’Brien refunds based on the deduction, the IRS brought suit in the U.S. District Court for the Central District of California to recover the amount attributable to the deductions. It asserted that Houdini does not manufacture or produce, but merely packages and repackages the items in its gift baskets, and therefore was not entitled to the deductions.

On cross motions for summary judgment, the court agreed with Houdini. It noted that although Section 199 requires qualifying production property to be manufactured, produced, grown or extracted (MPGE) by the taxpayer in whole or significant part within the United States, it does not define MPGE. In Reg. Section 1.199-3(e), however, an example is given of a company that purchases automobiles from unrelated persons and customizes them by adding ground effects, spoilers, custom wheels, specialized paint and decals, sunroofs, roof racks, and similar accessories. In this example, the IRS said that the company does not manufacture any of the accessories, and therefore its activity is minor assembly, which is not an MPGE activity.

The IRS said that Houdini, like the car customizer, merely performs a service that adds value to the final product. The court, however, distinguished Houdini’s production process from the car customizer in the example.

“Unlike X, which does not change the form or function of the car by adding accessories to it, Houdini changes the form and function of the individual items by creating distinct gifts,” the court stated. “Furthermore, the court considers Houdini’s complex production process as more similar to purchasing various automobile parts from suppliers –- such as the frame, engine, wheels, etc. and assembling them to create the car itself, which is undoubtedly manufacturing.”

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